Accounting policies refer to the specific principles, rules, and procedures a company follows in preparing and presenting its financial statements. Accounting policies are an important part of a company’s financial reporting, providing a consistent framework for measuring and presenting financial information. They also help to ensure that a company’s financial statements are accurate and reliable.

Examples of accounting policies include:

The method used for determining the cost of inventory

A company may use the First-In, First-Out (FIFO) method or the Last-In, First-Out (LIFO) method to determine the cost of its inventory. The FIFO method assumes that the oldest items in inventory are sold first, while the LIFO method assumes that the most recent items are sold first. The choice of method can significantly impact a company’s reported profits and taxes.

The method used for depreciating assets

A company may choose to depreciate its assets using the straight-line method, the declining balance method, or the sum-of-the-years’-digits method. The straight-line method spreads the cost of an asset evenly over its useful life. The declining balance method accelerates the depreciation rate in the early years of an asset’s life. The sum-of-the-years’-digits method also accelerates the depreciation rate but with a different calculation.

The method used for recognizing revenue

A company may use the accrual basis of accounting or the cash basis of accounting to recognize revenue. The accrual basis of accounting recognize revenue when it is earned, regardless of when payment is received. The cash basis of accounting recognize revenue only when payment is received. This can significantly impact a company’s reported revenue and profits.

It is important to note that accounting policies should be consistent from period to period and be in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) to ensure that the financial statements are comparable and reliable.

What are accounting estimates?

Accounting estimates refer to approximations of uncertain financial information companies use to prepare their financial statements. These estimates are necessary because some financial information cannot determine precision or is subject to change in the future.

Examples of accounting estimates include:

• Allowance for doubtful accounts: A company may estimate the number of accounts receivable that will not be collectable and record an allowance for doubtful accounts to account for this potential loss.

• Depreciation estimates: A company may estimate an asset’s useful life and the depreciation amount to be recorded each period.

• Warranty and product return estimates: A company may estimate the cost of warranty claims and product returns based on historical experience and record a liability for these costs in the financial statements.

• Impairment of long-lived assets: A company may estimate the carrying amount of long-lived assets, like property, plant, and equipment and record an impairment loss if the carrying amount exceeds the fair value of the assets

• Income taxes: A company may make estimates of its income tax liability based on its current tax laws and regulations and any potential changes in the future.

It is important to note that accounting estimates are subject to change as new information becomes available and actual results may differ from the estimates. Therefore, companies should regularly review and update their accounting estimates to ensure that their financial statements are accurate and reliable.

How are changes in accounting estimates and accounting policies treated?

A change in an estimate or accounting policy is treated differently depending on the nature of the change and the accounting principle being applied.

Accounting Estimate

Suppose the change in estimate is due to new information or circumstances that existed when the original estimate was made. In that case, it is considered a correction of an error and is recorded as a retrospective adjustment in the current period. The impact of the change is also reflected in the comparative financial statements of the prior periods affected.

If the change in estimate is due to new information or circumstances that did not exist when the original estimate was made, it is considered a change in estimate. It is recorded prospectively in the current and future periods. The impact of the change is not reflected in the comparative financial statements of the prior periods.

Accounting Policies

A change in accounting policy is treated similarly. If the change is due to a new accounting standard or a change in the company’s business operations, it is considered a change in accounting policy. It is recorded prospectively in the current and future periods. The impact of the change is not reflected in the comparative financial statements of the prior periods. Suppose the change is due to a correction of an error. In that case, it is treated as a change in estimate, recorded as a retrospective adjustment in the current period. The comparative financial statements of prior periods are also adjusted.

It is important to note that the change in estimate or policy should be justified and be in accordance with the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) to ensure that the financial statements are accurate and reliable. Also, any change in estimate or policy should be disclosed in the financial statements, including the nature of the change, the amount of the change, and the financial statement line item affected.

What are the causes for changes in accounting policies or estimates?

There are several reasons why a company may need to change its accounting policy or estimate, including:

• Changes in accounting standards: A company may need to change its accounting policy or estimate due to changes in accounting standards issued by regulatory bodies such as the Financial Accounting Standards Board (FASB) or the International Accounting Standards Board (IASB).

• Changes in business operations: A company’s business operations may change, requiring a change in its accounting policy or estimate to reflect its current activities better.

• New information or circumstances: A company have new information or circumstances which may not available be when the original estimate or accounting policy was implemented, such requires a change to ensure that the financial statements are accurate and reliable.

• Correction of errors: A company may discover errors in its financial statements requiring a change in its accounting policy or estimate to correct the errors.

• Improvement in measurement techniques: Advancement in technology or new measurement techniques that provides more accurate and reliable information, requiring change in accounting policy or estimate.

A company needs to regularly review and update its accounting policies and estimates to ensure that its financial statements are accurate and reliable. Also, any change in accounting policy or estimate should have a disclosure in the financial statements, including the nature of the change, the amount of the change, and the financial statement line item affected.